3 People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices. It is impossible indeed to prevent such meetings, by any law which either could be executed, or would be consistent with liberty and justice. Adam Smith, The Wealth of Nations, 1776 Sotiris Georganas () Collusion February / 31

4 Cartels Definition A cartel is a formal (explicit) agreement among competing firms. Anticompetitive agreements are observed to exist since ancient times First named cartels in Germany around 1880 for alliances of enterprises The name was imported into the Anglophone world during the 1930s Found to decrease welfare of consumers Outlawed in the USA by the Sherman Act (1890) although Adam Smith thought it impossible Public cartels permitted in the United States during the Great Depression in the 1930s Continued to exist for some time after World War II in industries such as coal mining and oil production Sotiris Georganas () Collusion February / 31

5 Cartels Cartels also played an extensive role in the German economy during the inter-war period. The word cartel got Anti-German bias in the 40s, as they were used by the enemy Illegal now in most countries (except international cartels) More frequent when there was no law against them (e.g. Rockefeller s Standard Oil) Some complicated forms survive, such as the Salary Cap in the NBA Pattern: some industries are more prone to cartel formation than others. Sotiris Georganas () Collusion February / 31

6 The incentive for cartel formation It s the money, stupid! Market demand functions are downward sloping. A firm that increases output imposes a negative externality on the other firms in that market by causing the price to drop. Implication Uncoordinated firm behavior leads to lower total profits than can be achieved through coordinated behavior. Sotiris Georganas () Collusion February / 31

10 But on the other hand, if the firms do coordinate and reduce their output levels, then each firm will have an incentive to cheat on the agreement by increasing its output: at the coordinated cartel optimum π i / q i > 0, for i = 1, 2. Sotiris Georganas () Collusion February / 31

14 Infinitely repeated games Infinitely repeated games are also called supergames. Suppose there is an infinite sequence of time periods: t = 1, 2, 3,... In each period, the duopolists simultaneously choose their quantities q t 1 and qt 2. They then get the profits π 1 (q t 1, qt 2 ) and π 2 (q t 1, qt 2 ). This is repeated in every period, and both players know all previously chosen quantities. The list of all chosen quantities prior to period t is called the period t history of the game [=everything that has happened previously in the game]. Sotiris Georganas () Collusion February / 31

16 Grim trigger strategies A strategy in a repeated game is a function. This function specifies, for any possible history of the game, which quantity a player chooses. Consider the following grim trigger strategy for Firm 1 in period t: If both firms have played the collusive output (q m i ) in all previous periods, play the collusive output in this period too. If at least one firm did not play the collusive output (some q i = q m i ) in at least one previous period, play the Cournot-Nash output (q c i ). Sotiris Georganas () Collusion February / 31

17 Check if it is an SPNE for the firms to use this strategy: First we check that no firm has an incentive to deviate unilaterally along the equilibrium path. (Requirement for having a Nash equilibrium.) Then we check the same thing off the equilibrium path. (Requirement for subgame perfection.) Reminder The sum of an infinite geometric series: 1 + δ + δ 2 + δ 3 + = 1 1 δ Sotiris Georganas () Collusion February / 31

20 Interpretation: By deviating, you make a short-term gain but get a lower profit in all future periods. So if you re patient enough (sufficiently large δ), then you resist the temptation to deviate. Sotiris Georganas () Collusion February / 31

21 Checking subgame perfection Any deviation is effectively punished by the competitor. Is carrying out this punishment credible? Imagine that we are in a subgame where at least one firm has previously chosen some quantity differing from the collusive output (some q i = q m i ). The grim trigger strategy prescribes that then each firm should choose the Cournot output (q i = q c i ). We must verify that this is a Nash equilibrium. Clearly it is! Sotiris Georganas () Collusion February / 31

22 Result: Summary and Theory Discussion Conclusion: We can sustain the outcome (q1 m, qm 2 ) (in every period) as an SPNE of the infinitely repeated game if the players care sufficiently much about the future (or, the interest rate r low enough). However, some potential issues with this equilibrium can be raised. Equilibrium multiplicity There are (many) other equilibria: For example, always playing the Cournot-Nash quantity is also a SPNE. Multiplicity of equilibria a problem with this theory no obvious prediction. The typical approach among IO economists: Assume the firms are able to coordinate on a collusive equilibrium whenever such exists. Renegotiation when collusion has broken down - Commitment problem The SPNE where the firms collude is not renegotiation proof: After a defection the firms are supposed to play Cournot-Nash forever. But both would be better off if they renegotiated and agreed to forget about the deviation and instead start to collude again. Sotiris Georganas () Collusion February / 31

23 Cartels: where, when and how? Effective cartels form when: 1 group action can raise price and profits; 2 enforcing an agreement is relatively easy; 3 the expected punishment is low relative to the gains; 4 the fluctuation in demand is low. Sotiris Georganas () Collusion February / 31

25 Cartels Enforcing the agreement: When easier? When there are few firms in the cartel. When there is high industry concentration; e.g. a dominant firm can take the lead. The product is relatively homogenous: easier to agree price and to monitor. There are preexisting inter-firm ties, e.g. trade associations which can facilitate information exchange. Prices are highly visible: e.g. depending on the type of the product. Players can use violence, e.g. guns (the Sicilian mafia tends to be an internationally successful cartel) Sotiris Georganas () Collusion February / 31

27 Cartels Small fluctuations in demand A decrease in the market price may be due to cheating or due to a drop in demand. Reduces the risk of being detected when cheating. Sotiris Georganas () Collusion February / 31

28 Cartel techniques Some techniques are well-known: Geographic- or quota sharing Most-favored-customer clause. Contractual commitment by a seller that all customers will pay the lowest price charged any customer. Makes it more costly for a firm to deviate from a collusive agreement (since it has to charge the lower price to all customers). Gives the customers a stronger incentive to watch out for (secret) price cuts, which then also the competitors can find out about. Meeting competition clauses (Never knowingly undersold): A way of obtaining information. Sotiris Georganas () Collusion February / 31

31 What to remember from this lecture What is collusion and why is there scope for collusion in the standard (Cournot-Nash) duopoly model. The logic behind how repeated interaction can make collusion self-enforcing when the firms are patient. Differences between cartel models and real life cartels Circumstances and practices that facilitate the sustainability of cartels. Sotiris Georganas () Collusion February / 31

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